August 14, 2023

What is a Swap Contract?

What is a Swap Contract? Modern Day Barter System??

If you have read history, you would have heard of this term called the barter system.  This was standard practice to make any form of transaction when the concept of money wasn’t introduced to mankind. The exchange of products and services between two or more parties without the use of money is known as bartering. It is the oldest form of trade. Individuals and businesses exchange commodities and services based on similar assessments of pricing and goods.

Our topic for today is Swap Contrat which works on the same principle. A swap contract is one of the four kinds of derivatives (the other being Forwards, Options and Futures). Derivatives are basically contracts between two parties. The value/price of such contracts depends upon certain underlying assets. 

So, because the value/price is derived from some other source, therefore, these contracts are known as derivatives. Shares of a company are the most common example of derivatives as the price of a share depends upon the value of its company. Similarly, one of the other kinds of derivatives is a swap contract.

Let’s find out about swap derivatives in detail…

Content:

Swap Derivatives

In simple terms, the word ‘swap’ means to give something for something else or to make an exchange. When two parties agree to exchange their liabilities or cash flows from separate underlying assets held by them in order to hedge their risks, then it is known as a Swap Contract.

However, the underlying asset in Swaps can be anything as long as it has legal and financial value. In most swap contracts, the principal amount does not change hands and remains with the original owner. While one cash flow is stable, the other is changeable and is determined by a floating currency exchange rate, benchmark interest rate, or index rate.

Swap Contract Example

For your better understanding, let’s take a simple swap contract example.

Assume that Ashmita lives in Lucknow and wants to eat apples costing ₹200/kg in the local market. Whereas there is another girl Sneha who lives in Kashmir and craves to eat mangoes costing ₹200/kg in her local market. 

Now the cost of the same apples in Kashmir is ₹50/kg, and that of the same mangoes in Lucknow is ₹50/kg. So both Ashmita and Sneha talk to Sanjay, who agrees to facilitate the exchange of apples for mangoes from Kashmir to Lucknow and vice versa for Ashmita and Sneha. So now both Ashmita and Sneha get to eat their favorite fruits at ₹50/kg.

Types of Swaps

Swaps are commonly of three types;

  1. Interest Rate Swaps: The objective behind this kind of swap is to shift the cash flow coming from a fixed rate of interest to a floating rate of interest and vice versa so that risk with respect to the interest rate can be hedged or speculation can be done. 

Let’s take interest rate swap example for better understanding. Company X takes a loan of ₹50 Crore on 10% floating rate of interest from lender L1, and Company B takes a loan of ₹50 Crore on 11% fixed rate of interest from lender L2. Now let’s assume that their requirements change. 

Now Company A thinks that it can’t take the risk of a change (in the form of a hike) in the floating rate of interest, whereas Company B thinks that 11% of the fixed rate of interest is too excessive for them. So both of these companies agree to swap their interest rates with each other as their principal amounts are the same so that they can meet out their requirements and hedge their risks at the same time.

  1. Currency Swaps: When two parties from different countries agree to exchange the cash flows in two currencies, then it is called a currency swap. For example, Mr. Australian wants to do business in India, whereas Mr. Indian wants to do business in Australia. 

Now the exchange rate of INR/AUD currencies can fluctuate quite frequently, which can result in losses in the businesses of Mr. Australian and Mr. Indian. In order to avoid such unprecedented losses, Mr. Australian and Mr. Indian can provide each other with a mutually agreed upon rate of exchange for the INR/AUD currencies.

  1. Commodity Swaps: In commodity swap exchange of cash flows is based upon the price of a commodity. Since the price of commodities keeps changing over the course, therefore, to avoid losses from fluctuation, a party may exchange the floating price of the commodity with a fixed price of that commodity ascertained over a period of time. For example, a farmer can exchange the floating price of his crops with a fixed price determined over a period of time.

Features of Swaps

  • Simply put, a swap contract is a forward contract only, and hence, it exhibits all the characteristics of a forward.
  • Swap contract is based on the system of barter wherein one thing is exchanged for the other thing.
  • In a swap, there must be two parties who have opposite and coinciding requirements so that they can exchange it with each other.
  • Presence of an intermediary is necessary who can bring together two counterparties with opposite but matching requirements for the swap.
  • Swap contract provides flexibility to the parties who can easily exchange their interest rates with each other.

Advantages of Swaps

  • Swap contracts are not expensive, and there are no premiums or big fees to be paid.
  • Swap contracts allow the two parties to borrow at a low cost from each other. 
  • Swap contract helps the parties in hedging their risks.
  • Swap contracts give the parties access to new financial markets so that they can explore new options and hedge their risks by exchanging their comparative advantages with one another.
  • Swap contracts can be fruitful in managing the Asset-Liability mismatch of parties by exchanging their interest rates, etc.
  • Swap contracts are a means for the intermediaries to make some additional income in the form of brokerage charges from the parties who want to enter into swap contracts.

Disadvantages of Swaps

  • Swap contracts are generally long-term arrangements, and hence they bind the parties for a long period of time with each other.
  • Swap contracts, if canceled, can result in the accrual of termination fees for the intermediary.
  • Penalty can be imposed on the party on whose default the Swap is breached or terminated.
  • Swap contract being a non-liquid instrument, is not immune from default risks.

 Difference between Swap and Option

  • Options contracts give buyers the right to buy or sell an underlying asset but not a legal obligation. Swaps are legally binding contracts where parties agree to exchange either revenue stream from two different sources.
  • In options, actual securities are traded. Swaps involve the exchange of revenue streams.
  • Options derive their value from the underlying assets. Swaps don’t.
  • Options contracts require the payment of a premium. Swaps don’t.
  • Options are traded on both regulated exchanges and over-the-counter. Swaps are only traded Over-the-Counter.
  • In options, losses are limited due to their nature. Swaps are riskier and carry unlimited risk.

Quick Summary

  • When two parties agree to exchange their liabilities or cash flows from separate underlying assets held by them in order to hedge their risks, then it is known as a Swap Contract.
  • Swap contract is one of the four kinds of Derivatives (other being Forwards, Options and Futures).
  • Swaps are commonly of three types viz. 
    • Interest Rate Swaps
    • Currency Swaps
    • Commodity Swaps.
  • There are several features of swaps like these are basically Forwards based on a barter system involving two parties having opposite but coinciding requirements. These are flexible contracts where the presence of intermediaries is necessary.
  • Advantages of Swaps include inexpensive nature, borrowing at a low price, hedging of risks, access to new financial markets, asset-liability management, etc.
  • Disadvantages of Swaps are – long-term arrangements, contract-termination fees for intermediaries, the penalty for contract-termination, non-liquid instrument, default risks, etc.
  • Options are traded on both regulated exchange or over-the-counter. Swaps are only traded Over-the-Counter.
  • In options, losses are limited due to their nature. Swaps are riskier and carry unlimited risk.

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